Delta Neutral Option Trading Strategy is an advanced option trading strategy used by traders. This strategy is generally used in neutral market condition.
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About Delta Neutral Option Trading Strategy
Readers will find the necessary insights on Delta Neutral Options Trading Strategy in this article. You will encounter the process along with explanation for better understanding.
Option trading strategies make use of different Greek values like delta, theta, etc. to predict the price of the options trade. These options Greek estimates the price by analyzing factors like time decay, volatility, interest rates, etc.
Delta is one of the most popular options for Greeks that defines the change in the price of the options.
Delta neutral option trading strategies are trading strategies that generate positions that do not get influenced by the small changes in the price of the underlying asset.
Such positions come by balancing the possible delta values to make the overall delta value zero or nearly zero. The traders create delta-neutral positions either to gain profits or to protect the positions from price changes.
Before moving on to the ways of generating profits and protecting, it is important to have a basic understanding of the delta values.
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Delta Values in Delta Neutral Option Trading Strategy
The delta value of an option explains how the value of an option would move depending on the change in the price of the underlying asset.
The delta values are often expressed within the range of 1 and -1. To explain better, if the delta value of an option is 1 then every 1 increase in stock price would result in an equivalent 1 increase in the option.
On the other hand, if the delta value of the option is -1 then every 1 increase in stock price would bring a corresponding Rs.1 decrease in the option.
Since each contract represents 100 stocks, a contract with delta value 1 is an option with 100 deltas. Therefore, if the stock price of an option with 100 deltas increases by Rs.1, then the trader would possibly make a profit of Rs.100.
The traders may have several options and an overall position comes by combining all the different delta values. The overall delta value would be 50 when the trader owns a 100 call option with a delta value 0.5.
The delta values behave in the opposite way when the trader sells or writes options apart from owning or buying them. That is, the total delta value would be -50 if the trader has written the call options with the delta value 0.5.
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How to create a Delta Neutral Position?
Delta neutral position happens when the total delta values become zero or nearly zero. We can bring this position using potion alone or by using options and stocks.
For instance, by using options alone, a trader can produce a delta neutral position in the following manner –
- The trader can buy an at the money call option with a delta value 0.5 and an at the money put option with the value -0.5, to create a 0 or neutral delta value.
- 5 (call) – 0.5 (put) = 0 (neutral)
Similarly, traders can create a delta neutral position using options and stocks simultaneously in the following way,
- The investor can buy 2 put options (100 contracts each) with the delta value -0.5, while owning 100 shares of the stock, to construct a neutral position.
- (2 x 100 x -0.5) – 100 (shares) = 0 (neutral)
However, it is important to note here that the delta neutral position may not remain constant and that it will change with the change in stock price.
That is, even a small decrease in stock price has to be compensated immediately by increasing the value of the put options.
This trading strategy of creating a delta neutral position is appropriate for investors who aim at reducing the directional risks and bias and to generate all possible profits from neutral market conditions.
The traders use the delta-neutral values to gain profits and to ensure the protection of positions.
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Methods of generating profit from delta neutral position
The delta neutral option trading strategies have the potential to generate profits in neutral conditions. We can accomplish the profit in the following ways:
Time decay refers to the rate at which the value of options drops with time. The time decay usually cuts down the profits due to the reduction in the extrinsic value of an option that the trader has. Traders can still make a profit under the effects of time decay by writing options.
They can write at the money call and put options simultaneously to create a delta neutral position along with creating profit. We can understand it better with an example.
- Consider a company trading its stock at 100, with both at the money call and put options trading at 3 each.
- The strike is 100 and the delta value of the call option is 0.5 and the delta value of the put option is -0.5.
- The trader can sell a call and put contracts (with 100 options each) to create a delta neutral position with the credit of 600.
3 x 200(100 call and put options) = 600
The trader gets the net credit as the profit in the delta neutral state, by writing options in time decay. However, the company stock price should not have any significant changes throughout.
Volatility refers to the deviations in the price of an underlying asset. Traders can get profits out of volatility by constructing a delta neutral position.
It is because highly volatile stocks are expensive while less volatile ones are cheaper. The following example can explain more about the use of volatility to make profits.
- A company trading its stock at Rs.100. The money call and put options are trading at Rs.3 each.
- Traders need to buy one call and put a contract (with 100 options each) at a strike price of Rs.100. The delta value of the call option would be 0.5 and that of the put option -0.5.
- The overall delta value would be neutral and the total cost for the trader would be Rs.600.
- The trader gets a profit when the stock becomes volatile. Profit can be made from calls if the stock price rises and from puts if the stock price goes down. Moreover, the trader can even make a fair amount of profit even if the stock exhibits a neutral trend.
This strategy is comparatively better than the effects of time decay. However, this method is best suitable only when the investor can expect an increase in the volatility of the stock.
This is not an absolute delta neutral trading strategy. However, it is possible to create a delta neutral position now.
He can then obtain profits by buying options at the bid price and selling options at any price.
Protecting positions using Delta Neutral Trading Strategy – Hedging
Traders can effectively use delta neutral trading strategies to protect the positions of the underlying security.
This strategy along with protecting the stock position from small price movements also improves the chances of profiting.
The trader profits from the position if stocks rise or fall. In this delta-neutral hedging, a trader has to buy twice at the money put options as the stock the trader owns, that is,
- 100 stocks – 100 delta value (-0.5 x 2 x 100) = 0 (delta neutral)
- The delta value is -0.5 as the traders buy at the money put options.
The stocks are protected and the trader can get profits even if the stock price moved dramatically in either direction.
Even though the trader has to invest money to buy the options, the protection provided is much greater. It is higher than the financial investment.
Despite having this greatest advantage, delta-neutral hedging also has certain disadvantages. It could be costly and the numerous transactions resulting from the need to adjust buying and selling.
It is according to the changes in stock.
Right use of Delta Neutral Option Strategy
Investors can use features like time decay and volatility of the options. It is to gain a considerable amount of profit in neutral trends. Along with profits delta, neutral strategies can be used in reducing directional risks.
We can also use it for hedging the positions from small price changes. The strategies involve numerous transactions and require constant attention from the trader.
It is to adjust the values to maintain the neutral value of delta. However, it is the benefit of the strategies that dominate the complexities of it.
Delta Neutral Options Trading Strategy – Conclusion
Delta neutral option trading strategies are used to create positions with delta neutral values. They do not get affected by the small changes in stock price. It is a kind of portfolio strategy involving various trading positions all balanced together to get a total zero delta value.
The delta values usually fall within the range of 1 to -1. Traders can either use different options or use a combination of options and stocks to create a neutral delta value.
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